30% Chance Of China Hard Landing; “Black Swan”: Societe Generale

A recent report from global megabank Societe Generale suggests that the bloom is definitely off the rose for the Chinese economy, and maintains a 30% chance for a problematic China hard landing in the next year or so. The SG team also revised their 2016 growth forecast for China down to 6% from 6.3% in a note which reviewed potential “black swan events“.

SocGen states:

On the major risks that we see over the coming year, one positive is that we have taken Grexit off the chart. Medium-term, we still consider a Grexit a high risk scenario, but for now euro area policymakers seem content to have given the can a good kick further down the road. China hard landing (30% probability): The recent market tumult offered a flavour of the type of market response a China hard landing might trigger. In such a scenario we would expect to see a further, and this time, sharp decline of the RMB. We defined a hard landing as a 2pp negative real growth shock to our baseline real GDP outlook. In 2015, that sets hard landing at 5%, in 2016 at 4%. China’s financial integration into the global economy is low, making a replay of the 2008 crisis – that was transmitted primarily via financial channels – less likely. To our minds, such a scenario would bear a greater similarity to a “classic” EM crisis, such as the 1997 Asia crisis. However, today emerging economies account for around 40% of global GDP. This is twice the level that prevailed in 1997. The pullback in demand in emerging economies would make such a scenario the third deflationary shock of the past decade, following the 2007/08 subprime crisis and the 2011/12 euro area debt crisis.

The quarterly report from SG’s Cross Asset Research is titled Global Economic Outlook: US-China Decoupling, and argues that global monetary policy divergences are likely to put pressure on a number of sectors of the global economy.

The SG team structures the report by comparing their views to the general analyst consensus. The SG position is well-above consensus on the U.S. economy and well below on China, leading to what they term a “U.S.-China decoupling”. The analysts note: “This call has important ramifications for the rest of our global forecast, depending on whether ties to US or China are more powerful and shaped also by domestic policies.”

Also keep in mind that much of the U.S.-China decoupling story links is connected to domestic demand. The report highlights that there will soon be a notable increase in residential investment in the U.S. The SG analysts also argue that a growing percentage of the relatively large sums saved from lower oil prices will start to be spent by consumers. On the other hand, it looks like the ongoing slowdown in fixed asset investment will continue in China, but don’t expect consumption to moderate too much except in a worst case China hard landing.

Of note, the Societe Generale team is also below consensus on economic developments in the euro area. They argue that the “slow pace of structural reform, combined with our long-held view that multipliers (notably when it comes to exchange rate effects) are low, shapes our below-consensus call on both growth and inflation.”

The SG analysts note they are also generally below consensus on emerging market economies in Asia and LatAm, but in line with mainstream consensus for somewhat stronger economic growth in Eastern Europe.

SG’s key policy and political developments in advanced economies

The report also argues that the start of the Fed rate hike cycle is pretty much priced in by markets. They point out that “market pricing on Fed tightening remains very soft and stands in contrast to our own view, marking a clear difference to the market consensus. Where we seem to agree, however, is on the view that QE may no longer offer the same insurance to risky assets.”

Another political issue of note is greater than expected Brexit risks. The SG team argues that a Brexit remains a 45% probability, with the referendum on the subject due by 2017. Moreover, markets do not seen to be pricing in this notable risk factor.

Differentiating euro area sovereign risk is also a key theme for the next year or two. According to the analysts, “The debate on the future fiscal union in the euro area is only in its very nascent stages, but as we discuss in Box 15, the initial signals suggest that seeking market differentiation of sovereign risks will be an important feature. This is the long-term theme, however. Short-term, the German Constitutional Court ruling on the OMT, expected sometime in 2016, marks the next key event.”